The over 250 consumer, employee, investor, community, small business and civil rights groups who are members of Americans for Financial Reform (AFR) write to express our opposition to attempts to weaken the bill’s “Volcker Rule” ban on federally-supported banks investing their own capital in private equity and hedge funds. Proprietary trading and private fund investments are resulting in taxpayer-supported banks using cheap federal funds to gamble, not lend to America’s struggling businesses and families.

As President Obama said, “we cannot accept a system in which hedge funds or private equity firms inside banks can place huge, risky bets that are subsidized by taxpayers and that could pose a conflict of interest. And we cannot accept a system in which shareholders make money on these operations if the bank wins but taxpayers foot the bill if the bank loses.”

That is why we urge you to oppose the effort to weaken the Volcker Rule by allowing so-called “de minimis” or “side-by-side” bank investments in risky, off-balance sheet private funds. Because bank capital is valued as mark-to-market while private funds are valued as mark-to-model, a 5% capital investment during a healthy market could quickly become a 25% capital investment during a crisis when bank assets are devalued. Bear Stearns invested only $34 million in its hedge fund, but eventually was forced to bail it out for over $3.2 billion.

Such a carveout increases the risk of future bailouts by allowing insured depository institutions with access to the Fed discount window to own and invest in high-risk leveraged funds. As a recent Cambridge Winter Center for Financial Institutions Policy report shows, private fund investments were the reason that Massachusetts-based custodial bank State Street received TARP and Federal Reserve bailouts in 2008-2009.[1]

The Merkley-Levin amendment, which may be the base text for the House offer, already allows for banks to sponsor and manage – though not invest – in private funds. We strongly believe that sponsorship is already a great concession that allows private fund risk into our taxpayer-backed banking institutions. Chairman Paul Volcker, chief architect of the Volcker Rule, also opposes any further weakening of this important structural reform.

AFR urges all conferees to reject weakening of the Volcker Rule and support a strong Volcker Rule based on the Merkley-Levin amendment, which would:

Prohibit Goldman-Style Bets Against Clients: Merkley-Levin would prohibit securities originators from engaging in any transaction that would give rise to a material conflict of interest or undermine the value, safety, or performance of an asset-backed security during the period the security is outstanding. While Goldman Sachs has recently been charged with fraud for such a conflict of interest, there is evidence that the practice of creating toxic securities, selling them to clients and then betting against them was widespread on Wall Street. It should be banned outright.

Remove the Study Requirement and Regulatory Deference: It is Congress’ right and responsibility to make the law. The Senate language would only allow regulations banning proprietary trading to be developed after a study by the Financial Stability Oversight Council and based on their recommendations. By taking this approach, rather than providing statutory restrictions, any newly-imposed regulations would be subject to the whims of Administrative politics—both in the years before they go into effect, and in the years to come. Merkley-Levin makes the prohibitions statutory, and provides for a study on how best to implement them.

Close Loopholes in the Definition of Proprietary Trading: The Senate language takes a narrower approach to the definition of proprietary trading, exempting many types of trading including involving “market making activities” or “hedging activities,” without defining those terms. The client-centered, market-making portfolios are where many firms are actually making many of their proprietary trades. Merkley-Levin will provide a broader definition, covering trading involving any purchase or sale of a security, or transaction involving a derivative (including swaps), as a principal, for a firm’s own account. The amendment would permit federal regulators to carve out specific market making or hedging activities.

Impose Higher Capital Standards and Position Limits on Non-bank Financial Companies: Both the Merkley-Levin amendment and the Senate language would impose additional capital requirements and limits on systemically important non-bank financial companies. The amendment makes it explicit, however, that additional capital is required for high-risk assets and trading strategies.

For more information, please contact Heather McGhee, Demos, at (202) 559-1543 or hmcghee@demos.org.